Naked Trading 101 - Part 1: Price action basics

 ‘Analysis paralysis’ is a common term I use when I see traders using a thousand and one indicators to plan a trade.

Stocks data board
Source: Bloomberg

Take a look at chart 1 below, does that look familiar?

It basically shows a chart that is cluttered with different indicators.

Trading is difficult enough, especially when it comes to managing one’s psychology; hence simplicity is better, which is the approach I like to take.

Chart 2 shows how I like my charts would normally look when it comes to analysis. 

CHART 1 - Click to enlarge
CHART 2 - Click to enlarge

In this first part of my five part series, I would like to introduce a leading indicator called price action. Price action is simply the purest form of data. It is the historical price plotted on a chart without any indicators.

Most traders are exposed to indicators like moving averages, MACD, Stochastic when they begin their trading journey. However, one thing to note is that indicators are mostly lagging by nature because they are dependent on price data on a chart.

While lagging indicators can be useful to confirm trends or reversals, it’s more beneficial for traders, especially when building a high probability trading plan, to understand leading indicators and how to combine them with lagging indicators. This is where studying price action on charts comes in.

Identifying swings

The first thing about price action is being able to identify swings in a chart. Swings are:

  • significant turning points on a chart, usually in the form of peaks and troughs
  • usually common around key support and resistance levels
  • variations in the number of candles
CHART 3 - Click to enlarge

Identification of swings can be discretionary, but more practice and ‘screen time’ can make a trader more aware of where the significant levels are. Looking at the chart 3 above, one can observe how swings, visual support and resistance react off one another.

Once swings have been identified, the next step is to label them.  There are four labels that you need to know:

  1. Higher Low (HL)
  2. Higher High (HH)
  3. Lower High (LH)
  4. Lower Low (LL)

The key thing to note when labelling swings is that you must only compare it to the most recent previous swing, not the two or three swings before. This will allow you to tell whether there has been a change in momentum and direction. Refer to chart 4 below as an example.

CHART 4 - Click to enlarge

Once you’ve identified the swings, the exciting part comes in – identifying phases in the markets. Markets move in phases, therefore as a trader it’s important to understand price action to identify which phase the market is in.

This would enable you to use the right tools and strategy to trade the market, as well as manage expectations in regards to stop loss placement and profit taking. Essentially the market only has three different phases:

  1. Uptrend – a series of higher highs and higher lows
  2. Downtrend – a series of Lower low and lower highs
  3. Consolidation – no specific sequence of swings. Usually forming chart patterns like a wedge, channel, head and shoulders etc
Trend patterns
TREND PATTERNS

Why is it important to understand which phase the market is in?

As a trader, it’s critical to be able to form a bias. A bias will give you a conviction on what kind of trade to plan and the appropriate strategies to use. Before executing a trade, you need to know whether it’s bullish, bearish or neutral.

That way you won’t be confused and swayed by news or sudden moves in the market. Planning a trade with no bias is like going into a war with no purpose and target in sight.

Once you have a bias based on the market phase, you can start building a trade plan to give yourself a high probability trade. For example, if the market is on an uptrend, I will be bullish and I will be looking for confluence levels of support like trend lines, chart patterns, visual levels to plan my entries.

I can also look at indicators like moving averages, MACD or stochastic to confirm my bullish view. It’s all about stacking the odds!

If there is one thing that the markets of 2014 taught us thus far, is that the trend is truly your friend. Understanding price action will enable you to identify swings on the onset and be aware of any trends that are forming. You can then capitalise on such moves and be part of the trends that can last for a considerable period of time.

In part 2 of the Naked Trading 101 series, I will elaborate more on trends and how to identify and ride them.

 

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